Behavioral biases are everywhere. These biases affect financial decision making in different ways but are by no means confined to the field of finance. Indeed, learning to recognize these biases might help in other aspects of life that require some sort of decision-making activity.
Moreover, behavioral biases affect experts and beginner investors alike and some can be very difficult to correct. Recognizing these biases is therefore extremely important to improve investment selection and to avoid preventable mistakes in investing and other walks of life.
It is also important to remember that these biases often come up in financial literature and/or can be given different names while referring to the same underlying bias. Following is a list of the main biases which I personally learned to recognize. The reader should keep in mind that the list is by no means complete and can always be expanded with new emerging biases.
This bias is definitely not confined to the financial realm. Framing bias refers to the way a choice or an option can be perceived differently depending on the way it is presented. For example, an offer touting “buy 4 for the price of 5” might look more appealing than “we offer a 20% discount”, even though they are the same.
This bias is also very common and refers to the tendency of an investor to maintain its prior views without properly incorporating new information. This leads to overweight initial beliefs against new information, and it is related to the “cognitive cost” (i.e. additional required study) of acquiring and processing new information.
Confirmation bias happens when people (not only investors) tend to look for information that confirms their previously held beliefs. This has become increasingly clear in the increasingly polarized political environment in the United States and the West, where social media has exacerbated political and cultural differences among population groups by feeding those groups mostly information confirming their previously held beliefs.
The same process is at work in investment decision making, particularly in regard to reading financial news that focuses on a positive investment thesis for a stock held in a portfolio and the tendency to ignore articles focusing on the negatives.
This bias is slightly more subtle than the former biases and involves investors classifying new information based on past experiences or classification. For example, new information
is deemed similar to something already known or experienced in the past and is classified accordingly.
This is the same as assuming small samples as representative of a population. A real-life example of this can be found in the deeply flawed polling methodologies that lead to big prediction errors in the U.S. Elections of 2016 and 2020 when small sample sizes were taken as representative for broader and more heterogeneous population groups.
People have a tendency to believe they can control or influence an outcome while they cannot. For example, a person considering himself as “smart” would be inclined to think that its last stock investment is a “sure bet” just because he/she has picked it. This bias also leads to excessive trading and can be mitigated by seeking contrary viewpoints and keeping investment records.
This bias leads investors to think that things that have already happened are predictable and reasonable to expect. For example, an investor might randomly invest in stock (or invest in it thinking it would go up for the wrong reasons) and see it skyrocket shortly afterward. The investor would therefore be tempted to think the successful outcome was due to its decision based on flawed data, while most likely it was the result of a random event.
These are only some of the investment biases affecting financial decision making. Stay tuned for Part 2, coming up soon.
Sources: CFA Level III Curriculum and personal knowledge
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